PBS NewsHour business and economics correspondent Paul Solman weighs in on whether to reduce debt or preserve cash

PBS NewsHour business and economics correspondent Paul Solman is now answering questions from Next Avenue visitors about personal finances, business and the economy. His advice appears on Next Avenue as well as Solman’s PBSNewsHour blog, Making Sen$e With Paul Solman, and the Rundown, NewsHour’s blog of news and insight. PBS NewsHour is an hour-long television program and accompanying website with the mission of providing intelligent, balanced and in-depth reporting and analysis of the day’s most important domestic and international issues and news.

Do you have a question for Paul Solman? Email it to us and we’ll pass it along.

I’ve read that in light of our sluggish economy, Americans should hold on to as much money as possible, because we’ll need even more of it just to keep the lights on when the dollar takes a nosedive. The suggestion is that we should not pay down mortgages or auto loans so that we can preserve cash. Do you agree? And if not, what do you suggest? —Barbara Ratliff

Goodness no, I don’t agree. Not in general and not in principle — though there are a few asterisks, which I’ll get to in a moment.

Look, the first thing to realize when you’re taking on and maintaining debt is that it’s costing you money. That is, you’re paying an interest rate. And that interest rate is almost always going to be higher than the return you’re earning on your investments, unless you take substantial risk as an investor, are very lucky or cheat.

Yes, it’s true that if the debt is a mortgage you can deduct the interest from your taxes. But every time I’ve done the calculation for myself, I’ve decided I’d be better off paying down the mortgage than keeping the loan as is and then investing the money I could have used to reduce the debt. That’s because I have to pay taxes on investment returns.

By all means, take the first available opportunity to refinance your debts to get the lowest possible interest rate. And had you asked about high-interest credit card debt or a loan you’ve taken out from local knee-breakers to bet with your local bookie, my answer would be quite different: Pay it down immediately, if not sooner. But as a rule, don’t take on more debt just to keep cash on hand.

When Not to Pay Down Debt

So then, you might ask, why would someone who can afford to pay down a mortgage continue to hold one? I can answer that, since it describes my own situation.

If we dipped into savings to shrink the mortgage, our family wouldn’t have enough cash on hand for emergencies — unless we withdrew money from our pension funds, a cumbersome and sometimes costly procedure (though we once borrowed from our pension funds for a bridge loan when closing on a house purchase before getting the money from a sale).

The usual rule-of-thumb for how much cash to keep on hand is three to nine months’ worth of living expenses. So that’s the first of my asterisks: It makes sense to have a financial cushion in case of a catastrophe. Once you have that cushion, you can then try to pay debt down faster.

The second asterisk: A mortgage can be an inflation hedge.

Say you take out a 30-year mortgage next week at an interest rate of 3.5 percent and the yearly payment will be $10,000. (For those of you worried about whether you’re too old for a long-term mortgage, this post and its follow-up should reassure you.)

Now let’s imagine that inflation spikes in the next decade to seven percent a year. Your wages rise seven percent. Your investment returns rise by seven percent. But you’re still paying a mere 3.5 percent in interest.

So if inflation were to spike, you would be ahead of the game. But this is a gamble. If inflation drops instead, you will be compelled to refinance to take advantage of the lower interest rates.

To come clean once again, I took out a mortgage eight years ago on the basis of just such a “hedge,” locking in an interest rate at what seemed a ridiculously low 4.87 percent. It wound up costing me money, since rates have fallen since then.

In a post I wrote a year ago, I noted my own asset preference and allocation. At the time, I had 55 percent in a TIPS mutual fund (TIPS stands for Treasury Inflation-Protected Securites), 13 percent in a foreign stock index fund, 10 percent in a foreign bond fund, 7 percent in a U.S. stock fund and the rest in bonds or cash, including a small bank account in Chinese yuan. Since then, I traded in the foreign bond fund for more Treasury Inflation-Protected Securities because the European situation made me too nervous.

But only you know what investment allocation makes sense for you.

Paul Solman is a member of the Twitterati and can be followed at [email protected]. His daily blog can be followed, well, daily at Making Sen$e by linking here, or just Googling the words: “Making Sense.”

Paul Solman is the business and economics correspondent for PBS NewsHour. He has taught at Harvard Business School and his alma mater, Brandeis University, and now teaches at Yale and Gateway Community College. His reporting has won multiple Peabody and Emmy awards. He is co-author of Social Security, Get What's Yours: The Revised Secrets to Maxing Out Your Social Security.@paulsolman